Capital Gains Tax Overview
Smart investors aren't paying capital gains taxes in 2008... Will you be one of them?
Understanding capital gains and the capital gains tax can certainly feel daunting. However, whether you’re investing in stocks, bonds, or real estate, you’ll want to understand the impact capital gains taxes will have on your finances.
What is capital gains tax?
The IRS requires you to account for investment sales on your yearly tax return and pay a capital gains tax on the monetary gain that you’ve made. Depending on your income and length of rate, your capital gains tax will vary. Short-term capital gains are taxed at a rate equal to your individual income tax rate, which will normally be a higher rate than the long-term rate. The long-term tax rate can range from 0-28% (through 2010). However, you can be taxed at 0% by doing a 1031 exchange. Both capital gains and losses are reported on Schedule D, and then transferred to line 13 on IRS form 1040. Most people dont realize that they may qualify for a zero percent capital gains tax rate on many investments by doing a 1031 exchange!
Who qualifies for the 0% rate?
First, you should note that if you have lived in a residence for two of the five years before the sale date, you are eligible to exclude up to $250,000 of capital gains on your property (as a married couple, you and your spouse may exclude up to $500,000). Additionally, owners of investment real estate may qualify for a 0% tax rate if they do a 1031 exchange.
How Can I defer paying capital gains taxes on investment real estate?
Yes, the IRS code section 1031 (aka 1031 exchange) allows investors to defer real estate capital gains taxes. This section applies only to the exchange of “like-kind” business or investment property but does not apply to exchanges of stocks, bonds, or other securities. Properties are considered like-kind if they are the same in nature, character, or class. Investment real estate is tradeable for investment real estate when doing a 1031 exchange. That means you dont have to pay capital gains taxes on investment real estate if you do a 1031 tax exchange!
What is a capital gain?
An increase in the value of an asset between the time of purchase and the time of sale is considered a capital gain. Profits on investments such as stocks, mutual funds, bonds, real estate, fine art, and other collectables are classified in this category. Capital gains are divided into two categories: short- and long-term. Short-term capital gains are profits realized on investments held less than one year, while long-term capital gains are realized on those held more than one year.
What if my capital losses exceed my capital gains?
Often, individuals have both short-term capital losses and long-term capital gains. Depending on the investments you’ve made and the length of time you have been investing, your losses might end up being higher than your gains. In these situations, the excess is subtracted from the income on your tax return, up to an annual limit of $3,000.
Do I have to pay capital gains tax on the sale of my home?
One of the more common types of capital gains that must be reported on your tax return is the income on the sale of your primary residence. As previously mentioned, you may be able to exclude a portion of this gain if you lived in your residence for two of the five years before the sale date. Additionally, even if you don’t meet the two-of-five-years rule, you might still qualify for a reduced rate.
How can I determine my own tax rate on capital gains?
While many believe that the long-term capital gain tax rate is a standard 15%, this is certainly not always the case. Your tax rate is dependant upon many individual factors such as your income-tax bracket, the type of investment sold, the length of time you held onto it, and date of sale.
How can I calculate my capital gains?
There are various methods for calculating capital gains depending upon the type of investment. To keep the best record, either for yourself or your accountant, be sure to keep all receipts and records for purchases, investments, brokerage fees and commissions, and dates. Additionally, it’s recommended that you keep a running spreadsheet or use finance software, such as Quicken to stay organized. When selling your home, add all occurred expenses, such as the purchase price, purchase costs, improvements, and selling costs. Then, subtract any accumulated depreciation to figure out your cost basis amount. Finally, subtract the cost basis from the selling price. A positive total is a capital gain; a negative total is a capital loss.
Do I need to report capital gains from tax-deferred investments?
Investments through a tax-deferred retirement account are not reported as capital gains. This might include IRAs, Roth IRAs, and 401(k) plans. Any income from these accounts is tax-deferred until the money is withdrawn and then reported as ordinary income.
While there are many details to understanding capital gains and the capital gains tax, these basic principals will help get you started in the details of your investments. As you begin to invest and keep records of your assets, you’re sure to begin developing a better understanding of capital gains.
Getting the Most of Your Investments: Real Estate Taxes and the Capital Gains Tax
